This article discusses how defined benefit pensions paid from defined benefit schemes are accessed, their quirks and recent proposed changes to their assessment under the transfer balance cap.
Defined benefit (DB) pensions are normally non-commutable lifetime pensions. DB pension entitlements are calculated based on variables, such as final salary, contributions and years of service, rather than a purchased amount. How these pensions are accessed, taxed and assessed for social security can be very different to the more familiar account-based pension.
In this article, we discuss how DB pensions paid from DB schemes are accessed, their quirks and recent proposed changes to their assessment under the transfer balance cap.
Eligibility to commence a defined benefit pension
Under some DB schemes, members who cease employment with an employer who had contributed to the fund may access their preserved benefits as a non-commutable lifetime pension regardless of age. This option is available to eligible members of DB schemes who leave their contributing employer (generally the Federal Government or a State Government) and elect to draw a non-commutable lifetime DB pension. A pension may also be drawn when the member satisfies a full condition of release, such as retirement.
A credit equal to the ‘special value’ of the DB lifetime pension will arise in the member’s transfer balance account when the DB lifetime pension commences. This will be discussed in more detail later in this article.
Transfer balance cap
Since 1 July 2017, legislation has limited the amount of superannuation benefits that can be transferred into ‘retirement phase’. In addition, another new concept, the ‘transfer balance cap’, was introduced. The transfer balance cap limits the amount a member can transfer to a retirement phase superannuation income stream which benefit from tax-free earnings. Retirement phase income streams are valued against the member’s transfer balance cap.
The term ‘retirement phase’ replaced ‘pension phase’ to distinguish income streams that count against the transfer balance cap and whose earnings were tax-free. Earnings on assets supporting a transition to retirement income stream became assessable, unless the member met a specified condition of release, such as retirement and notified the super fund trustee or when they reach age 65.
A DB pension alone cannot exceed the transfer balance cap
Clients who exceed their transfer balance cap are ordinarily required to commute the excess, together with any notional earnings, otherwise the ATO will issue their super fund a ‘commutation authority’, directing the fund to commute the required amount.
DB lifetime pensions commenced at any time are classified as ‘capped DB income streams’ and are excluded from compulsory commutations, as DB lifetime pensions cannot ordinarily be commuted under their governing rules.
The special value of a DB lifetime pension, rather than the commencement value, counts towards the member’s transfer balance account but by itself cannot result in an excess transfer balance. Where the member has other retirement phase income streams, such as an account-based pension, in addition to their DB lifetime pension and exceeds the cap, the member may have to commute part or all their account-based pension.
The special value of a capped defined benefit income stream also counts towards the member’s total super balance. The total super balance is a measure of a client’s total super interests at 30 June of the last financial year and is used to assess eligibility for:
SMSF trustees adopting the segregated assets method in determining Exempt Current Pension Income; and
SMSF trustee Transfer Balance Account Report requirements.
Calculating the special value
The special value for a DB lifetime pension is based on the annual entitlement multiplied by 16. The annual entitlement is calculated as:
First payment / days in period it relates to x 365
For example, if a member’s first DB lifetime pension payment is $2,500 per fortnight, the special value is calculated as:
Annual entitlement x 16 where:
Annual entitlement = ($2,500 / 14) x 365
Special value = $65,179 x 16
Issues with changes to pension payments
Currently, the first pension payment is used to calculate the DB lifetime pension’s special value and any subsequent increase or decrease in pension payments does not affect the member’s transfer balance account. While pension payments may be indexed annually, the DB income cap is not.
An unfair transfer balance cap assessment might arise if subsequent pension payments reduce, such as where:
the DB lifetime pension reverts to a spouse and the first pension payment is equal to the deceased’s last payment, but after which future payments reduce to a proportion of the deceased’s last payment; or
a reversionary DB lifetime pension, for example, a reversionary MilitarySuper DB pension, which pays an additional fortnightly amount for a dependant child living with the eligible spouse. This payment will cease when the child is no longer a dependant under the scheme rules.
Draft regulations propose that a transfer balance debit be recorded to reflect permanent reductions in the value of DB lifetime capped defined pensions. The proposed amount of the debit is effectively the earlier special value, based on the first pension payment received, less the special value that would have arisen had the initial payment been the new lower amount.
If the first payment received by the reversionary is $4,800 for a 14-day period, then the special value would be $2,002,286.
If the reversionary pension subsequently fell to $3,216, then the special value for the later period would be $1,341,531 and the transfer balance debit would be $660,755. This is calculated in Example 1:
Where the special value of the earlier benefit is:
If the reversionary beneficiary is not intending to make contributions that are restricted by the total super balance (as outlined earlier), a significant special value counted towards their total super balance may not be an issue. The member may only be concerned with losing any tax concessions for excess capped DB income.
Capped defined benefit income cap – concessional tax treatment
While DB lifetime pensions cannot, by themselves, result in exceeding a member’s transfer balance cap, they are subject to a DB income cap, currently $100,000 per financial year. The DB income cap seeks to limit concessional tax treatment only to capped DB income payments within the cap. Tax concessions are not available for excess capped DB income. The DB income cap is linked to the general transfer balance cap and is calculated as,:
$1,600,000/16 = $100,000
The general transfer balance cap is indexed in line with CPI in $100,000 multiples, meaning it may not increase each year. When next indexed, it will increase to $1,700,000, which will increase the DB income cap to $106,250.
Indexation of the DB income cap broadly compensates for any indexation in pension payments, which is generally in line with CPI. The DB income cap applies to members who are eligible to receive ‘concessional tax treatment’, namely those who are:
aged 60 or over;
in receipt of a death benefit pension and the deceased or the beneficiary is aged 60 or over.
Table 1 illustrates how different tax components are assessed if the DB income cap is applicable.
Taxable component – taxed element
Taxable component – untaxed element
Below preservation age
Marginal tax rate*
Marginal tax rate
Preservation age to 59
Marginal tax rate less 15% tax offset
Age 60 and over, the amount within the DB income cap
Marginal tax rate (less 10% tax offset)
Age 60 and over, the amount exceeding the DB income cap
50% assessable at marginal tax rates
50% assessable at marginal tax rates
Marginal tax rates (no tax offset)
* 15 per cent tax offset applies if the member met the permanent incapacity condition of release.
Paul, who is 61, has a hybrid defined benefit pension and receives $180,000 of defined benefit income in 2017-18. His pension comprises $85,000 from an untaxed source, $75,000 from a taxed source and $20,000 is a tax-free amount. The combined taxed source and tax-free amount of $95,000 is counted towards Paul’s $100,000 defined benefit income cap. $5,000 of the untaxed source income is also counted towards the cap, exhausting it. The remaining $80,000 of untaxed source income is denied a tax offset under section 301-100 of the ITAA 1997. Paul’s section 301-100 tax offset is limited to $500 (10% of the $5,000 counted towards the cap).
The same outcome would occur if the elements were from separate superannuation income streams, regardless of when either income stream was established.
Decrease in subsequent pension payments and the pro-rated defined benefit income cap
The DB income cap is reduced proportionately where the member receives capped DB income and becomes eligible for concessional tax treatment part way through the financial year.
The pro-rated DB income cap is calculated based on the remaining period in the financial year from the time the member commenced receiving the pension as follows:
Example: Reversionary DB lifetime pension
Lukas, age 62, commenced receiving a reversionary DB lifetime pension on 24 February 2018 when his spouse, the original member, passed away. Lukas has no other capped DB pension. The DB scheme rules provide that the first seven payments are equal to the deceased’s fortnightly payments ($4,800) and thereafter reduces to 67 per cent ($3,216). As Lukas has attained age 60, the pension payments receive concessional tax treatment. The pro-rated DB income cap is
= $100,000 x (1 + 126) / 365
= $100,000 x (127 / 365 or 34.79%)
Lukas’ pension payments between 24 February 2018 and 30 June 2018 were $40,032 (calculated as (7 x $4,800) plus (2 x $3,216)). Lukas will exceed the DB income cap by $5,237.
The date the DB lifetime pension reverts may influence whether Lukas exceeds the DB income cap. For example, if that same DB lifetime pension reverted on 1 July 2018, his DB income cap would be $100,000. His capped DB income in financial year 2018-19 would be $94,704 (calculated as (7 x $4,800) plus (19 x $3,216)). In this scenario, all his capped DB income will receive concessional tax treatment.
Social security assessment
DB lifetime pensions are generally not asset tested for social security purposes. Under the Centrelink income test, the entire pension payment less any deductible amount is assessed. Note DB lifetime pensions are not deemed and are not subject to recently legislated means test changes relating to pooled lifetime income streams.
The deductible amount is any tax-free component of the pension payment and is limited to 10 per cent of the total pension amount. DB lifetime pensions paid by the following military superannuation funds are excluded from the 10 per cent maximum deductible limit:
In summary, DB lifetime pensions have a favourable assessment under the Centrelink assets test but potentially an unfavourable assessment under the income test.
How DB lifetime pensions are accessed, taxed and assessed for social security can be very different to the more familiar account-based pension. It is necessary to research the product specific rules relating to your client’s DB lifetime pension, as each scheme will have its own unique features.
However, a basic understanding of the general concepts of how they are accessed, taxed and assessed for social security purposes will assist in guiding your client’s retirement planning.
Stuart Sheary, Senior Technical Services Manager, IOOF.
1. Item 108 SISR Schedule 1. 2. Events that increase or decrease your transfer balance cap are recorded in the transfer balance account. Events that reduce your transfer balance cap, such as transfers into retirement phase income streams, are recorded as credits. Events that increase your pension transfer balance cap, such as lump sum commutations from a retirement phase income stream, are recorded as debits. The sum of credits and debits must not exceed one’s transfer balance cap which is currently $1,600,000. 3. The general transfer balance cap is $1,600,000 and indexed to CPI in $100,000 increments. 4. ITAA 1997, Section 303.4. 5. Social Services and Other Legislation Amendments (Supporting Retirement Incomes) Bill 2018.